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ETF Specialist

Hidden Value in Small-Cap Dividends

While it doesn't take a traditional approach, this small-cap dividend ETF offers one of the best ways to unlock the value premium.

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Holdings can say a lot about a fund's investment style, but they don't always tell you everything. Take  WisdomTree SmallCap Dividend (DES) for example. It invests in dividend-paying small-cap companies that meet certain liquidity requirements. It then weights them by the dollar value of dividends they are expected to pay out over the next year. While its holdings skew toward the small-value side of the Morningstar Style Box, on average they trade at richer valuations than the holdings of its peers, which explicitly target small-value stocks (see the Portfolio Characteristics table below). Yet, since its inception in July 2006, DES has behaved like a deeper value fund than nearly all of its peers.

The fund's performance revealed its true colors. Just a few factors can explain most of the returns on a broad stock portfolio, including the portfolio's sensitivity to the market, value, momentum, and small-cap premiums. These are well-documented sources of return. Value stocks tend to outperform growth stocks, small caps tend to do better than large caps, and stocks with high momentum continue to outpace their low-momentum counterparts. By regressing a fund's returns on each of these factors, we can evaluate where its returns actually come from. For instance, if a fund does well when value stocks do well, then it behaves like a value fund, even if it doesn't own value stocks.

Alex Bryan has a position in the following securities mentioned above: VBR. Find out about Morningstar’s editorial policies.

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